Indonesia's financial system collapsed in the aftermath of the crisis. Non-performing loans now exceed 50 percent of bank assets. As Arnold Harberger emphasized at this Conference, the majority of borrowers have gone on a debtor's strike. Those that are truly distressed refuse to pay interest and principal; those that are only wounded, refuse to pay interest. Most Indonesian corporations have also defaulted on bonds issued to domestic and foreign creditors.

The government's response was to create a restructuring agency aimed at preventing a total collapse of the banking system, the Indonesian Banking Restructuring Agency (IBRA). IBRA is financed by a mix of medium and long-term government-guaranteed bonds, some inflation-indexed, others not. These bonds pay high rates of interest, approximately 14 percent annually. IBRA has exchanged these bonds for the worst non-performing loans in the banking system (so-called category 5 loans). In the process, IBRA has acquired some Rp. 500 trillion of assets ($85 billion, measured at face value, not market value). IBRA essentially owns the Indonesian banking system (apart from a few foreign banks, which have a small share of the financial market). As a consequence, IBRA has become the dominant creditor to most the large Indonesian corporations and property developers.

Meanwhile, Indonesian banks are struggling with their remaining bad (but not hopeless) category 2, 3 and 4 assets, and making very few new loans. Even after unloading their category 5 loans to IBRA, most banks have negative net worth and are far from meeting capital adequacy standards. Indonesia non-bank financial markets are relatively small (share, bond, commercial paper, etc.) and accessible to very few borrowers. The result, as Harberger stressed, is a general credit freeze, and government ownership of vast swaths of the economy, indirectly through IBRA and directly through state-owned enterprises (airlines, cement, petroleum, etc.).

In the run-up to the crisis, many Indonesian corporations incurred dollar-denominated and yen-denominated loans from foreign creditors. In many cases, the loans carried an explicit or implicit government guarantee. The amount of "private" external debt (including state bank debt), guaranteed or not, roughly totals $74 billion. Few if any debt service payments are now being made. As a consequence, fresh external credit is virtually unavailable to Indonesian firms.

On top of the "private" external debt, government and state enterprise external debt totals an additional $72 billion. Thus, Indonesia's total external debt (as of March 1999) was $146 billion. In addition, non-residents hold about $3 billion of Indonesian equity securities.1

The road to financial ruin was paved, of course, with mismanagement - ranging from weak regulation and poor supervision by Bank Indonesia, to non-disclosure of external borrowing and non-performing loans, to connected lending by state-owned and private banks, to outright fraud.

Indonesia's legal system is weak. The rights of secured creditors exist on paper, not in practice. While a new bankruptcy law has been enacted, its implementation remains to be tested. One should not be hopeful Court-ordered liquidation and foreclosure proceedings are practically unknown in Indonesia. Defaulting corporations and other debtors can defy their creditors almost indefinitely.

But even if Indonesia's laws on secured debt and bankruptcy were as severe as those in Australia, and its court system as efficient and honest, financial wreckage of the present scale would overwhelm the legal system. The tribulations of a case-by-case approach in the weaker legal environment of Thailand are sorrowfully explained by Pakorn Vichyanond.2

If Indonesia pursues a case-by-case cleanup of the financial wreckage, relying on the existing legal system, certain outcomes seem foreordained:

Proceedings will drag on for a decade or longer, as they get tangled in a weak legal system with high political overtones;

Meanwhile, much of the non-agricultural economy will remain under government control (IBRA plus state-owned enterprises), practically ensuring widespread inefficiency and corruption;

The recovery process will stagger along, as it has in Japan over the past decade. Years of sub-par performance will ensue, and the era of 7 percent GDP growth will become a distant memory.

To prevent this gloomy prognosis, I propose a bold eight-point program. The program is designed not only to clean up the wreckage in a speedy fashion, but also to set Indonesia on a new course of modern finance. It is designed, as Gus Papanek emphasized at the Conference, to restore the confidence of Indonesians and foreigners alike in the "Indonesian miracle".

Point One: Financial Rectitude. The era has passed when financial misdeeds are punished by public whippings or severed hands. But the public officials and private financial managers who set the stage for collapse prior to 1997 must be called to account. The worst offenders, those who committed fraud, should be sent to jail. Those who were merely negligent should be fired. Offenders should be barred from holding positions in regulated financial institutions for a period of years, even for life.

Bank Indonesia should post on its public website a running account, bank-by-bank, quarter-by-quarter, showing the number of senior bank managers who have been replaced. At the moment, the same bad managers who ran the banks prior to the collapse continue to hold their jobs. This is no way to establish public confidence in the financial system.

Point Two: Transparency. All banks and major corporations indebted to IBRA, together with all state-owned enterprises, should be required to report key financial magnitudes on a quarterly basis with a lag of no more than 90 days. The president and directors of firms that fail to comply should be subject to personal fines, say in the amount of Rp.100 million per offense. The key financial magnitudes should be reported electronically in a standard format prescribed by Bank Indonesia. The data should be immediately posted on Bank Indonesia's website. Among other figures, banks and corporations should report:

Point Three: Blue Ribbon Commission. Indonesian corporations (including the state banks, but excluding the state-owned enterprises) now owe about $72 billion of foreign exchange debt. Some of the loans and bonds were guaranteed by the government, implicitly (via the government's responsibility for the state banks) or explicitly. And some of the guarantees were improperly or corruptly procured. Many political figures now argue that the Indonesian government should not be responsible for these debts.

This is an explosive issue. If the government simply walks away from financial guarantees extended in the Suharto era, Indonesia will have difficulty obtaining new external credits for several years. And its diplomatic relations with creditor countries, such as Japan and the United States, will be strained. On the other hand, impoverished Indonesian taxpayers should not be stuck when foreign creditors colluded in the misdeeds of the Suharto regime.

My proposal is that the new government should form a Blue Ribbon Commission, headed by a financial figure of world stature - a person such as Ross Garnaut, or Domingo Cavallo, or Paul Volcker, or Karl Otto Poehl, or Raymond Barre. The Commisson should apply two tests to determine whether government guarantees were improperly or corruptly obtained:

Was the guarantee properly disclosed, at the time it was extended, to responsible officials in the Ministry of Finance, Bank Indonesia, the International Monetary Fund, and the public? If there was a failure of disclosure, a rebuttable presumption of impropriety should attach to the guarantee. In other words, in these cases, the burden of proof would fall on the holder of guaranteed debt to establish that the guarantee was proper.

Was the guarantee extended to benefit a project sponsored by a firm controlled by a member of the First Family or its long-time political allies? If so, then a rebuttable presumption of corruption should attach to the guarantee. The burden of proof would fall on the holder to establish that the guarantee was free of corruption.

Quick resolution of external guaranteed debt is an essential step before Indonesia can reestablish access to foreign credits. Accordingly, the Commission should wind up its determinations by December 31, 2000. The manner of holding hearings and the evidence taken should be tailored to meet this timetable.

As a working proposal, the face value of improper guarantees should be cut by up to 25 percent, while the face value of corrupt guarantees should be cut by up to 100 percent. Reducing the face value of the guarantee would not, of course, exonerate the debtor. It would, however, reduce the government's obligation to pay if the debtor failed.

Point Four: Extraordinary Powers for IBRA. IBRA should be granted extraordinary powers to liquidate defaulting corporations and foreclose on collateral. A new Special Court with simple and swift procedures should be established. The Special Court judges should be men and women of impeccable reputation.

The Special Court should hear only cases brought by IBRA and its judgments should be final. Decisions should be rendered in accordance with the new bankruptcy law. The claims of creditors, other than IBRA, against the same debtor should be simultaneously heard by the Special Court, if and only if those other creditors authorize IBRA to act as their trustee (with normal fiduciary obligations) in resolving their claims.

IBRA and the Special Court should operate on a strict timetable. Final decisions should be rendered within two years from the date IBRA acquires an asset (shares, bonds, mortgages). Special Court decisions should authorize IBRA to liquidate the firm, foreclose the real estate or personal property, sell the asset, and convey a clear legal title (subject to the claims of creditors who do not authorize IBRA to act as their trustee) to a new buyer.

The creation of these extraordinary powers and the Special Court will prompt many debtors to reach a voluntary resolution with IBRA before the Special Court rules on an IBRA petition. Debtors will know that they can no longer string out the day of reckoning by tying up the legal system.

Point Five: Extension of IBRA Mandate to Corporate Debt. IBRA's current mandate extends only to bank restructuring and loan made by banks. However, most large corporations have borrowed from foreign or domestic creditors other than Indonesian banks. These loans and bonds are not being serviced, and most of them have no prospect of being paid in full.

IBRA should be authorized (but not required) to purchase these non-bank loans and bonds at whatever discount it can negotiate with the current holders. IBRA may choose to acquire these loans and bonds in the secondary market, buying anonymously through one of the large international banks. Once IBRA has acquired a loan or bond, it can then use its extraordinary powers and the Special Court to liquidate the firm, foreclose the collateral and sell the assets to a new buyer. This prospect will, of course, speed up resolution of all corporate debt, not just bank loans.

Foreign and domestic creditors, including bondholders, who do not choose to sell their loans to IBRA (directly or through the secondary market), and who do not elect to name IBRA as their trustee in Special Court proceedings, can of course resort to the normal tedious and inefficient Indonesian court system. These creditors would not have the right to bring cases to the Special Court. That right would be unique to IBRA.

Point Six: Create a Modern Financial Market. In many instances, IBRA will be unable to reach a speedy and just resolution with the debtor. Instead, it will need to liquidate the firm and foreclose on collateral. In selling these vast foreclosed assets to new buyers and restoring a private economy to Indonesia, IBRA has been charged with twin goals, goals that are in tension with one another: obtain the best price and sell the assets swiftly.3

In addition to these goals (which are the subject of Point Six), Indonesia should seize this unique opportunity to create a modern financial market. In Indonesia's new financial market, the role of banks should be drastically curtailed, and the role of shares, bonds, mutual funds, and insurance companies should be dramatically enlarged. In this way, Indonesian financial markets in the 21st century will become far more efficient at increasing shareholder value and ensuring high returns on Indonesian savings.

To create a new financial market, IBRA should attach these conditions when it works out a settlement with existing debtors at a discount or sells foreclosed assets to new buyers:

Payment should be in cash. The existing debtor or new buyer should not be permitted to borrow from Indonesian banks to finance its settlement or purchase. Instead, the existing debtor or new buyer must obtain funding from a non-bank financial institution (such as an insurance company), from external sources, or by floating shares or bonds in the Indonesian market.

In the case of corporations of significant size, for a period of ten years after the existing debtor has settled or a new buyer has acquired, the corporation should be required to obtain any new capital by floating shares or bonds in the Indonesian market. Moreover, it should be required to maintain a conservative equity-to-debt ratio on fresh capital raised, say 2-to-1.

Point Seven: Act Fast but Keep Options and Acquire Equity. There is tension in IBRA's mandate to obtain the best price for foreclosed assets (or to reach the best settlement with existing debtors), but to act swiftly. The great danger is that government-appointed managers will become too comfortable and cautious, and that debt settlements or asset sales will be long delayed in the search for the best price. The result will be prolonged stagnation, as vast stretches of the Indonesian economy remain wards of the state, year after year.

To avoid this outcome, a tight deadline should be imposed on IBRA. It should have no more than one year to reach a settlement with existing debtors. If IBRA cannot reach a settlement, it should foreclose and sell each asset to a new buyer within two years of the date of its acquisition. The target date for winding up IBRA operations, shutting down the agency, and winding up the Special Court should be December 31, 2002. To achieve this target, many debts will be settled at steep discounts, and many assets will necessarily be sold at bargain prices to new buyers. That will happen even with the best-qualified debt workout negotiators and the best-organized auction procedures.

My suggestion to balance the mandate of swift action with the mandate to obtain the best price involves the use of options and equity. Let me start with the case of a foreclosed asset that is sold to a new buyer. Every time IBRA sells a major asset (such as shares in a big corporation, or a large office building) to a new buyer, IBRA should retain an option to repurchase one-half the shares, or one-half the property, at an "adjusted price". The option would have a duration of 15 years (roughly the term of government bonds issued to finance IBRA). The "adjusted price" would be calculated as follows:

One-half the initial price received by IBRA; with the principal increased annually by the 15-year government bond rate at the date of sale; and with the principal decreased by the amount of any dividends or other distributions made in respect of the asset.

Under this arrangement, the new buyer knows that, if the option is exercised, it will receive at much as it would have earned by purchasing government bonds. Meanwhile, the public knows that if the price turned out to be a great bargain simply because there were few bidders at the auction, or if super private management subsequently improves the value of the asset, the government will receive approximately one-half of the benefit. Obviously, if the asset turns out to be a loser, the government will not exercise the option.

In the same spirit, IBRA should obtain an equity stake whenever it works out a debt settlement at a discount with an existing debtor corporation. IBRA should receive equity in the corporation equal to half the difference between the face value of the debt and the cash settlement. For this purpose, a recognized independent appraiser, nominated by IBRA, should value the equity.

The combination of fast sales and settlements with retained options and equity stakes will front-load the government's cash recovery from IBRA operations. This will help reduce the public debt more quickly than would happen if sales and settlements were spaced out over a long period of time.

Some of the assets that IBRA sells, and some of the firms that resolve their debt, will turn out to be winners and others will turn out to be losers. As options are exercised and shares are sold in winning corporations, more of the government bonds used to finance IBRA can be paid off.

Point Eight: Don't be Afraid of Foreign Buyers. Indonesia's problem today is not too many foreign firms, but too few. Available evidence indicates that foreign firms operate more efficiently, bring new technology, and pay better wages. They should be welcomed, not rejected. On the other hand, every country harbors some resentment when foreign buyers appear to be acquiring assets at a fire sale. These are days of distress in Indonesia, and if IBRA acts quickly, it will sell some assets cheap.

To resolve this tension, IBRA is instructed to give a preference to Indonesian parties, either by settling their debts or by according a preference to Indonesian buyers of foreclosed assets. Debts should not, however, be settled at an excessive discount, and the terms of all settlements should be publicly disclosed. In the case of asset sales to new buyers, the Indonesian preference should be expressed in a transparent form. For example, foreign-controlled bidders might be required to pay a premium of 10 percent over Indonesian-controlled bidders.

Notes

1. For data on Indonesian financial magnitudes, including external debt, see, The World Bank, Indonesia: From Crisis to Opportunity, July 21, 1999.